Tax treaties between India and other countries incorporate non-discrimination clauses to ensure fair and equitable treatment of individuals and entities across borders, irrespective of tax residency. The essence of a non-discrimination clause in a tax treaty is that the individuals or entities of one treaty country should not be discriminated against under the other country’s tax laws solely because of their nationality or residence. The provision is aimed at treating non-residents and residents on an equal footing as far as the taxation of income is concerned.
However, some tax treaties entered into by India (such as those with the US and Japan) also encompass a non-discrimination provision in respect of the allowability of deductions to a resident payor, irrespective of whether the payment is made to a resident or a non-resident payee. The courts in India have shed light on the application of such non-discrimination clauses to deductions claimed by Indian residents.
Relevant provisions of tax treaties
As an example, the India–US tax treaty provides that interest, royalties, and other disbursements by an Indian resident to residents of the US are deductible under the same conditions as those applicable to payments made to Indian residents. This is subject to an obvious and just exception in the case of payments made to any overseas associated enterprise, which will be subject to transfer pricing principles.
Similar non-discrimination clauses can be found in treaties entered into by India with countries such as Japan, the Netherlands, Luxembourg, Germany, and Switzerland.
Relevant provisions under Indian domestic tax law
Historically, Indian tax law contained provisions to restrict deductions in respect of payments made to non-residents, if applicable withholding tax provisions were not complied with by the payor. However, the similar condition was not prescribed in respect of payments made to Indian residents. In other words, a payor was entitled to claim a deduction regarding a payment made to an Indian resident even if applicable taxes were not withheld from the payment. This resulted in differential tax treatment for payments made to residents and non-residents.
In an attempt to eradicate this discrepancy, amendments were made in 2004 and 2014 to impose restrictions on deductions in respect of payments made to residents without an applicable tax deduction, albeit with some variations in the scope and percentage of the disallowance.
The amendment in 2004 initially proposed full disallowance of payments made in the nature of interest, commission, brokerage, fees for technical services, contractual payments, and fees for professional services, without applicable tax withholding. However, the amendment in 2014 restricted the disallowance to 30% of the payment, while widening the scope to include all payments to residents requiring tax withholding in India.
Thus, presently, deductions regarding payments made to non-residents are disallowed in their entirety if applicable taxes are not withheld, whereas the disallowance is limited to 30% in the case of resident payees/recipients.
This led to a debate as to whether such differential treatment violates non-discrimination clauses under tax treaties.
Indian court’s decision
The High Court of Delhi, in Commissioner of Income Tax v Herbalife International India Pvt. Ltd. (2016) and The Commissioner of Income Tax-II v Mitsubishi Corporation India Pvt. Ltd (2014), has dealt with the application of non-discrimination clauses in such circumstances. These decisions emphasised the need for non-discrimination not only in the allowability of deductions regarding payments but also as a consequence of any non-compliance with tax withholding from such payments.
In the first case, the question was whether a non-discrimination clause can be applied for a deduction claimed in respect of an administrative fee paid to an associated enterprise based in the US prior to 2001. The court held that the essence of a non-discrimination clause is not with respect to a requirement to withhold tax per se but the consequence of failure to withhold tax. Since at that time the provisions did not require any disallowance for similar payments made to residents, the court applied the non-discrimination clause and held that no disallowance could be applied in respect of payments to non-residents.
Similarly, in the second case, the question again arose with respect to payments made to US and Japanese entities for purchases by an Indian resident. The reason for non-deduction of tax was that the non-resident sellers did not have any permanent establishment in India and, hence, the amount paid was not taxable in India. Be that as it may, the Indian resident payor contested the proposal to disallow an expense by invoking the non-discrimination clause under the India–US tax treaty, as during the relevant time, there was no provision prescribing a similar disallowance in the case of a similar payment made to residents. The court followed its earlier ruling and held that the provision for disallowance of an expense paid to non-residents violates the non-discrimination commitment set forth in the treaty.
It is worth noting that the court did not expressly interpret the phrase “same conditions” appearing in the relevant non-discrimination provision in the treaties. Though the court implicitly correlated “same conditions” with the consequence of a disallowance triggered by non-compliance with the withholding tax provisions, one might argue that “same conditions” fundamentally refers to the similarity in conditions under which a deduction of an expense is allowed to residents and non-residents. For instance, a deduction is permissible if:
The expense is incurred for business purposes;
The expense is not capital or personal in nature; and
The relevant tax withholding compliance thereon has been made.
Thus, the difference in disallowance because of non-compliance with the withholding tax provision (i.e., 30% vis-à-vis 100%) can be argued to be not covered under the ambit of “same conditions” and may not attract a non-discrimination clause per se. This may also be justified on the basis that while there are several means for the collection and recovery of tax from a resident, the same opportunities may not be available in the case of a non-resident and hence the disallowance at the higher rate is called for in the case of payments to non-residents.
Implications of the rulings
The above rulings have added new dimensions to non-discrimination clauses in tax treaties. Taxpayers can benefit from these decisions if they find any direct or indirect discrimination between the tax treatment of residents and non-residents having treaty protection. Logically, the non-discrimination clauses should equally protect taxpayers against differing quantum of disallowance (100% in case of non-residents and 30% in the case of residents).
However, one needs to be cautious that the issue regarding a claim of benefits or protection under treaties by Indian residents was neither questioned by the tax department nor examined by the court in these cases. It will be interesting to see how this aspect is dealt with in the future.
